What is Diversification Anyway?


There seems to be some confusion on diversification, so let’s chat about what it is and how to not be over-diversified.

Diversification basically means not keeping all of our eggs in one basket, our investments vary, we don’t just have one investment.

We should be diversified to a degree, but there becomes a point of diminishing returns. There comes a point when diversifying too much will actually diminish our returns, in other words, our returns will start to go down (we don’t want that, in case you’re wondering).

WIth investing, there’s lots of ways to diversify. For today’s post, we are sticking to investing in the stock market.

Not being diversified at all would be buying a bunch of shares of just one stock. For example, if you emptied out your 401k and invested all the money in Amazon stock.

This is considered VERY HIGH risk. Having all of your money in one company is risky because what if that company went out of business? Goodbye ALL of my money.

One way to diversify is to buy lots of shares of lots of individual stocks, but this is very expensive, so not the best option for diversifying.

Another way is to buy a fund that invests in lots of different stocks. This is what we like. They are less expensive to purchase than individual stocks and we are still diversified because own a portion of all those different stocks.

An easy way to be diversified is to purchase fund(s) with lots of stocks inside them and that follow the total stock market or S&P 500. They usually have lower fees because they are following, or tracking, something else. These are called index funds.

Buying lots of different funds is over-diversifying. A lot of funds will invest in the same stocks, so we aren’t really ‘diversifying’ if we are buying different funds if the funds have the same stocks inside anyway.

Let me give an example.

Say we buy Tiff Fund and it includes these stocks: Amazon, Google, Facebook, Costco, Netflix.

Say we decide to buy Tash Fund as well and it includes these stocks: Amazon, Google, Facebook, Steve Madden, Apple.

See how we are overlapping with our investments? We have two different funds, but within those funds, we now have 3 of the same stocks.

If we are buying more than one fund, we need to make sure we aren’t overlapping on the majority of stocks inside the fund. If we are, there’s no point in doing it.

Also, we need to be careful in buying too many different funds because of the fees involved. Each fund has an expense ratio. Funds will have anywhere from 0.05% up to (and over) 1.00%. If we aren’t careful and are buying too many funds with high expense ratios, we won’t be making as much as we thought because we’ll be paying more money in fees.

To keep investing simple and still make great returns, we need very few index funds with lots of stocks/bonds inside them.

What do you think? How many funds are inside your investment portfolio?

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